The growing involvement of highly-leveraged hedge funds in the increasingly uncertain global credit markets could lead to a major destabilisation in any downturn, according to a new report from Fitch Ratings, the credit experts.

This conclusion will worry investors at a time when a number of hedge funds, including two run by Wall Street firm Bear Stearns, have already moved to liquidate their credit positions because of problems related to the US sub-prime mortgage market.

Ian Linnell, a managing director at Fitch, said: "There is a growing perception that the credit cycle may be turning, which would lead to an up-tick in corporate defaults."
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Yet these concerns have not held back the rapid growth of the market for credit derivatives, which is being fueled by aggressive hedge funds on the lookout for new ways to trade.

The total amount of credit derivatives traded last year was around $50 trillion, more than double the $23 trillion of transactions carried out in 2005, according to Fitch.

Due to their growing investment in credit derivatives, hedge funds' influence on "key segments of the credit markets" has continued to "grow at a dramatic pace", the study found.

Fitch cites recent research from Greenwich Associates that showed that hedge funds are responsible for nearly 60pc of all trading volume in credit-default swaps and one-third of volume in collateralized debt obligations, another type of structured credit product.

Mr Linnell said: "Hedge funds love credit derivatives because they can go long or short on credit positions and it's yet another instrument to use in their strategies, alongside equities, foreign exchange and interest rates."

But while hedge funds have helped to boost liquidity in the credit markets, their influence is not all benign.

The Fitch report, which was based on interviews with 65 banks and other financial institutions, concluded that because hedge funds are borrowing so much money to invest in credit derivatives, they might find it hard to offload these substantial positions in any downturn.

"The uncertain outlook for credit markets, combined with the large positions taken by hedge funds - which is magnified by the leverage strategies adopted by many of them, may well result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side," the study said.

Mr Linnell added: "Should something happen in the hedge fund sector that causes them to unwind their credit derivative positions, liquidity would dry up and credit markets would become more volatile."